Danger: Watch for Falling Dollar

The balancing act the Federal Reserve and the politicians are playing
with the US economy will mean a cheaper dollar and an ascendant Asia in coming
years, observes Axel Merk of Insights.

One of the US economy's greatest attributes has been its flexibility, in
large part a result of the allowance of free market forces. While massive
monetary and fiscal efforts in the US and globally may have compromised these
free market forces, we believe they will play out over the long term.

In our opinion, the US dollar is a natural valve to allow the US economy to
adapt to global market dynamics; we consider both free market forces and the
unintended consequences of monetary and fiscal policies may push the US dollar
lower over the long term.

The recent financial crisis has in many ways exacerbated the global
imbalances that concerned us leading into the crisis. Of grave concern is the
unsustainable federal budget deficit, which may have morphed out of control.
More worrying still, is that despite a lot of political grandstanding and
rhetoric, we are yet to see any tangible evidence of fiscal restraint from
either political party.

Contrast this with the stance taken by many other governments around the
world, which have enacted stringent austerity measures. With a sluggish economy
likely to hamper tax revenues, we are unlikely to see any marked improvement in
public finances over the near-term. The notion of a balanced budget seems a very
distant thought when overlaying the near-term outlook with the budget
implications of long-term obligations, such as Medicaid, Social Security and
Medicare.

Put simply, the fiscal position of the US has deteriorated significantly, and
we consider the outlook remains challenging. We believe this situation is likely
to wear away at the safe haven status the US has held for so long. As alluded to
above, many other countries have been more fiscally prudent and now find
themselves in much healthier fiscal positions relative to the US.

The US current account (trade) deficit remains at unsustainable levels,
despite recent improvements. The current account balance is what the US earns
from other countries (exports, services, investments abroad) less what the US
pays to other countries (imports, services, loans).

The balance on trade (the difference between exports and imports of goods and
services) is the largest driver of the US current account deficit. In our
assessment, the narrowing of the deficit in 2009 was attributed to a weak US
economy and consumer, rather than the strength of the US export sector-in fact,
the economic downturn caused both exports and imports to fall, it's just that
the rate of decline was more pronounced for imports given the weakness of the US
consumer. To put the present current account deficit into perspective, the net
shortfall between what the US earned and what the US paid in 2010 was $470.9
billion.

Another way to look at this number is that foreigners had to purchase nearly
$2 billion worth of US denominated assets (such as U.S. Treasuries) every single
business day just to keep the US dollar from falling.

Additionally, we believe the Federal Reserve's (Fed) actions will likely
result in continued devaluation of the US dollar. When a central bank
substantially increases the money supply, all else held equal, the central bank
causes inflation, a devaluation of the currency's purchasing power. The Fed has
been one of the more prolific money printing central banks around the world,
increasing its balance sheet more than threefold since the beginning of the
global credit crisis (in simple terms, a central bank's balance sheet can be
thought of as money that has been printed).

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In our opinion, there is a significant divergence in monetary policies around
the world, with the majority of other central banks not following such easy
monetary policies relative to the Fed. In contrast to the Fed, other central
banks appear more reticent to conduct quantitative easing or implement other
"non-standard" monetary policy measures. The composition of the Fed's balance
sheet also gives us cause for concern: in our view, the massive amount of agency
mortgage backed securities (MBS) the Fed has purchased will create extreme
levels of inflexibility on the Fed's balance should inflation break out,
reducing the Fed's ability to counteract such an occurrence.

While we see considerable risks domestically, we believe there are attractive
international investment opportunities. On a long-term view, we anticipate that
Asia may outpace most western economies, including the US, attracting global
investment and putting upward pressure on the value of many Asian currencies.
Many Asian nations have substantial surpluses and much healthier fiscal
positions than the US.

Moreover, most countries in the region have focused on growing their domestic
economies, spending on the likes of infrastructure, growing the middle class and
urbanizing the workforce. A likely side effect of such rapid domestic growth may
be increased inflationary pressures. In our view, allowing these currencies to
appreciate may be an effective way to address and mitigate domestic inflationary
concerns. As such, inflationary pressures may force the hand of Asian countries
following tightly managed exchange rate policies, such as China, to allow their
currencies to appreciate.

Strong, ongoing Asian economic growth will likely sustain the demand for
commodities and natural resources. Countries rich in such resources may fare
well, and ongoing Asian demand will likely benefit the currencies of such
nations over the long-term. We consider that countries whose governments display
greater fiscal restraint and responsibility will increasingly be viewed as
sought after sources of stability; over time such countries may supplant the US
as safe haven investments.

Additionally, in our assessment, the monetary policies pursued by central
banks globally will have a marked impact on currency valuations over the
long-term. Relative to the Fed, we believe many international central banks are
more effectively fostering an environment of price stability and as such, the
currencies of such nations may retain significant value relative to the US
dollar. Consequently, on a long-term view, we favor the currencies of nations
that are well placed to benefit from ongoing Asian economic growth, display
fiscal restraint, and whose central banks' pursue prudent monetary policies.